What Slowdown?

China continues to be a rising power in the global economy, but accessing private equity opportunities in this evolving market has become more complex in the recent past. After years of high growth, China’s GDP growth grate hit its lowest mark in five years in the third quarter of 2014

Decreasing GDP in China doesn’t concern Baird Capital. What interests us more is the volume and speed of change in the Chinese economy, market and ways of life. We see these as the drivers of future opportunity.

Gradual Growth: The Advantage of Slower Expansion

2014 presented a number of key events for investors to consider. In October, China surpassed the United States and became the world’s largest economy (in terms of purchasing power, according to data from the International Monetary Fund). After China initiated transformative market reform in the late 1970s and shifted away from a state-planned economy, decades of impressive economic expansion and social development followed. China is now transitioning to a slower, more measured pace of economic growth – and asserting its position as one of the major players in the global economy.

Today, China’s economy is slowing to a more sustainable pace, creating a potentially more stable investment environment. The World Bank estimates China’s 2014 gross domestic product (GDP) growth at 7.6% – a minor decrease from 2013’s expansion of 7.7%.

China’s economic shift is prompting many private equity investors to reevaluate their China strategies, and they should.Mindful of the shifting dynamics, Baird Capital’s China Growth Equity team invests in subsectors and companies that are changing with the evolving Chinese economy, and many of our portfolio companies are growing despite the slowdown in the Chinese economy.

Embracing Change: Market Evolution as a Path to Opportunity

Baird Capital has been anticipating a shift in China away from a manufacturing-driven economy to a predominantly services-driven economy. We believe this dynamic is very much in progress and see it evolving in real time, both in our portfolio and on the ground. In fact, in many cases Chinese consumers and the companies providing them with services have leapfrogged their U.S. and European competitors in terms of technology and solutions.

Take mobile e-commerce, for example. Sophisticated brick-and-mortar retail is relatively rare in second- and third-tier Chinese cities, particularly in inland areas. Despite the lack of easily accessible goods and services, Chinese consumers – including many members of the nation’s rising middle class – are finding ways to spend their increased disposable income through the use of e-commerce.

In fact, they are skipping two key retail phases that dragged on in the U.S. for years – they are bypassing brick-and-mortar retail and traditional e-commerce channels and jumping straight to mobile e-commerce. What’s more, they are embracing mobile e-commerce in droves. During its most recent Singles Day shopping sale, Alibaba Group generated $9.3 billion USD in sales, with mobile purchases accounting for 42.6% of those sales.

The evolution of China’s healthcare system is another area we are watching closely. Like many of its geographic neighbors, China is coping with an aging population and the subsequent strain on capital, existing infrastructure and resources. However, there is a compelling dynamic in the combination of rising incomes for China’s middle class, its willingness to pay out-of-pocket for medical care and the availability of high-quality healthcare products and services.

Chinese patients pay as much as 35% out-of-pocket for healthcare services. Rising incomes and changing needs are outpacing the state-owned healthcare system. It cannot keep up with patient and broader population demands, creating unique opportunities for private, creative players to deliver innovative solutions.

Exiting the Market: Creativity and Persistence Are Essential

Investors in China-based companies can access the same exit routes that exist in the West: an IPO, a trade sale, or a sale to a fund. The proportions simply differ from those in Western markets. While exiting an investment has proved difficult in previous market cycles, the current exit ecosystem is maturing and new avenues are opening to industrious investors.

Due to the sizable deal backlog in China’s IPO market, public offerings are not a viable option for investors seeking an efficient exit. However, trade sales and secondaries are taking place – motivated investors are finding opportunities to exit their investments. The notion that Chinese founders will never sell their business is also evolving. Trade sales in China continue to be challenging because a win-win solution often requires two entrepreneurs. While this is not a simple exit path, it is not impossible. These transactions must be carefully and creatively engineered and pushed with consistency toward completion. Disciplined, creative investors with the drive to understand what the entrepreneurs on both sides of the table want will be able to attain this exit path.

Looking Toward 2015

Baird Capital sees a variety of meaningful opportunities in China. We believe the Consumer, Healthcare and Education markets will yield a number of compelling opportunities in the next three to five years.

Baird Capital has had an active, on-the-ground presence in Asia since 2003, with a dedicated team of investment and operations professionals working with our 60 companies globally, including 11 in China. This provides our firm with firsthand insight into China and the current market environment.